Does Arbitrage Flatten Demand Curves for Stocks?

Jeffrey Wurgler and Ekaterina Zhuravskaya

The Journal of Business, 2002, vol. 75, issue 4, 583-608

Abstract: In textbook theory, demand curves for stocks are kept flat by riskless arbitrage between perfect substitutes. In reality, however, individual stocks do not have perfect substitutes. We develop a simple model of demand curves for stocks in which the risk inherent in arbitrage between imperfect substitutes deters risk-averse arbitrageurs from flattening demand curves. Consistent with the model, stocks without close substitutes experience higher price jumps upon inclusion into the S&P 500 Index. The results suggest that arbitrage is weaker and mispricing is likely to be more frequent and more severe among stocks without close substitutes.

Date: 2002
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